Has Our Retirement System Failed or is it a Problem With Expectations?
There has been a lot of talk about retirement lately on the heals of a devastating market drop. Most investors saving for retirement are heavily invested in stocks so the market downturn took their account value with it. Those who are near retirement are often put in a position where they can no longer retire as expected or may have to suck it up with a reduced nest egg.
So, there’s good reason that the 401(k) plan has been on the hot seat. With most employees lacking a full pension plan and the expectation that Social Security will only barely provide enough income to pay a few bills, the weight of retirement falls squarely on your own retirement savings — and for most people that comes from their 401(k) or IRA. But when these plans don’t live up to all the hype a lot of people are being left high and dry.
Let’s start with the benefits of the 401(k). The obvious benefit comes from the special tax treatment. When you think about it, a 401(k) is just a few lines of tax code anyway. With a 401(k) you have the ability to reduce your current taxable income by making contributions. In addition, you defer taxes until withdrawal so your money can grow even faster.
Some people are fortunate enough to work for an employer who matches some of their contributions. This “free” money can really help accelerate the building of your nest egg.
And let’s not forget how easy it is to take part in your employer’s 401(k). It’s all done through payroll deduction so you don’t have to worry about setting up an account somewhere, making deposits, or any of that. It couldn’t get any easier.
While there are many benefits to these plans, they don’t come without drawbacks. One thing to note is that 401(k) plans are not mandatory. Not all employers offer them and those that do may restrict the benefit to full-time employees. This puts a lot of workers in a situation where saving for retirement in a 401(k) isn’t even an option. Some companies also do not match contributions.
In many cases these plans have very limited investment choices and may include funds with high expenses. It isn’t uncommon to be charged 2% annually on the investments in a 401(k) compared to the fraction of a percent charged if you were to go out and invest on your own.
And finally, there are a lot of restrictions that come with a 401(k) plan. You have special withdrawal requirements, have to keep it with your current employer unless terminated, and of course the penalties for premature distributions.
Does the Bad Outweigh the Good?
If you ask some people in Congress, they call the 401(k) “little more than a high-stakes crapshoot” and would like to scrap them entirely. But are these plans really as bad as they make them out to be?
There are obviously some glaring problems with our retirement programs, but you know why? They are all centered around taxes. When was the last time you thought of our tax system as streamlined? Exactly. It doesn’t matter if you’re talking about a 401(k), 403(b), 457, Traditional IRA or Roth IRA, each one of these so-called retirement plans are just fancy words for special tax treatment. No more, no less.
Because of the emphasis on taxes these plans are primarily used by those with higher incomes. The more money you make, the more taxes you pay, so the harder you’re going to work to reduce your tax bill. Your typical working-class American earning $30,000 a year can usually care less about shaving a few hundred dollars off their taxes even if they could afford to put some money aside for retirement. To try and sweeten the deal the government even began offering a tax credit for lower income employees who save for retirement in a 401(k) or IRA and most people still don’t take advantage of it.
Lack of participation and not saving enough for retirement are the problems, yet all you hear about from lawmakers is about the fees and optional nature of these plans that need to be fixed. There are clearly fee issues that need to be addressed as these are cash cows for the investment companies who offer them, but let’s think about it for a moment. If you can’t get people to save for retirement by offering tax deductions, tax credits, and in some cases even free company match money, do you really think trimming fees by a percent and making sure each plan offers a few index funds is going to suddenly put people on track for retirement? Of course not. It would certainly be beneficial for everyone who is saving in a 401(k) but it’s far from the actual problem.
Let’s fix the problems with 401(k) plans where we can, but let’s also realize that most people simply don’t save enough for retirement. Period. And you won’t be solving that problem by maintaining a voluntary system that offers nothing more than a little tax break.
There is also a problem with expectations. For years we’ve been told to just continue to stick money in a retirement plan and come time for retirement you’ll have a pile of money. Ok, sure. If you continue to put part of each paycheck aside and don’t touch it for 25 years, chances are you’ll have some money to retire on. Unfortunately, the expectations of saving money, compound interest, and time are often just crude marketing tools used by the financial industry to encourage saving. While this can certainly lead to wealth, retirement planning goes far beyond this simple formula. But people have just latched on to the expectation that if they save 10% of their paycheck they will magically have all the money they will ever need in retirement. As we all know, it doesn’t quite work that way.
I don’t have to say much about expectations when it comes to investment returns. We all know how dangerous that can be. People will say stocks return 10% a year on average. Sure, if you dig up enough data, history does indicate that. But average return does not equal actual return. When people use compound interest calculators to predict the size of their nest egg a compound interest calculator can be very dangerous since it literally compounds the same rate of return year after year. We all know that doesn’t happen in real life and there will be years or even consecutive years with losses. While it may all average out in the end, those bad years can take a toll on any portfolio, especially if an investor makes changes during that time.
So, just expecting that if you save money you’ll be fine, or that if you invest in stocks you’ll average double digit returns, or that asset allocation can prevent you from losing money is dangerous. It’s time for investors to readjust their expectations in line with reality. Is it the 401(k)’s fault that you lost 40% of your portfolio of all stocks when the market dropped? Is it the 401(k)’s fault that you didn’t accumulate a million dollars before retirement because you were only saving 3% of your income? There are clearly some areas that need to be improved, but many of the faults have nothing to do with retirement plans at all and are just a function of investor behavior.
Buy and Hold is Not the Same as Buy and Forget
One of the arguments coming out of this recession is that buy and hold is dead. Over the past ten years stocks are flat. You could have made more money by hiding it under the mattress or leaving it in a savings account. When people see that they have not made any money in ten years by investing in stocks it’s an easy argument to make. You bought, you held, and you didn’t make a dime.
The problem isn’t that buy and hold doesn’t work, it’s that most people buy and forget. You can’t just throw some money in the market and expect everything will just turn out fine when you’re 65 and ready to start drawing on it. You have to be involved with your retirement savings and understand that your goals, needs, the market, and investment objectives are constantly evolving. You need to rebalance your portfolio, you need to begin shifting assets around as you get closer to retirement, and you probably need to change how much you contribute to your plan over time.
Buy and hold just means that you invest some money with the intention of holding it for a while instead of trying to time the market. It doesn’t mean you pick a few funds to invest in, set your contribution rate to 5% and never look at your account for ten years and just assume everything is fine. Unfortunately, that’s what many people do with their retirement accounts and then they are shocked when something doesn’t go as planned.
Consider this. Would you go to the gas station and fill up your car with gas and then hit the freeway, get up to 70 mph and set the cruise control and let go of the wheel and take a nap just hoping when you wake up you’ll be at your destination? Of course not, that’s insane! But that’s exactly what most people do with their life savings. They put a little gas in their tank with each paycheck and then hit cruise control just hoping by retirement everything will turn out fine.
Some Final Thoughts
There is clearly some room for improvement with our retirement programs. The 401(k) landscape is very complicated and it doesn’t put everyone on the same playing field. These aren’t mandatory plans so some people don’t even have access to them, others are offered with poor investment choices, and even more with high fees. So you can have two people working identical jobs making the same amount of money while working for different employers and their retirement options can be completely different.
People just aren’t saving enough for retirement. That’s the problem. We can identify all the deficiencies that retirement plans have, but it won’t solve the problem of people not saving enough, if at all for retirement. Giving people a minimal tax deduction or even a tax credit isn’t enough to encourage more savings, so what’s next? I don’t have the answer, but I know that basing the entire retirement system on a few tax benefits will never be the solution. People should be saving for their future whether they get a tax break for doing so or not, but it just doesn’t happen.
So, is the 401(k) broken? I don’t think so, but I do think it’s a bit like driving a 20 year old car with 250,000 miles. Things don’t work as well as they used to and it’s probably missing some now common new features, but it will get you from point A to point B if you use it properly and take good care of it. The 401(k) is due for a tune up, but it is still a valuable tool for those who take advantage of it and know how to use it.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.